Navigating Commodity Markets: The Role of Hedgers and Speculators | Agriculture, business and agritourism news

Every day, commodity futures markets facilitate over 1 million trades as market participants respond to technical and fundamental market signals – two topics we have covered in previous articles (“Technical Analysis” and “Fundamental Analysis”).

But who are these market participants?

Broken down to the most basic level, these participants can be divided into two camps: hedgers and speculators.

These are terms used to describe participants' motivation when making trades. What is important is that no group is more important than the other. Efficient and effective markets require the participation of both, otherwise we would not be able to find a real price for any commodity.

The fundamental goal of a hedger is to reduce the price risk of his physical commodity. The phrase “hedging a bet” first appeared in a theatrical performance in 1672, but is generally used to indicate placing a barrier – a shrub-like hedge – between yourself and something else.

In financial terms, this means balancing one financial position with an opposite position. This may seem counterintuitive, as it might appear that hedging in this way would produce a net return of zero (the profit from one position would equally offset the loss from another position).

But effective insurance is not a zero-sum game. Rather, effective hedging puts a stop to dramatic price fluctuations, which ultimately leads to a return.

Hedgers are those in the market who actually own or purchase the physical commodity they are trading. There are many hedgers in agriculture: farmers, ranchers, grain elevators, ethanol producers, livestock producers, dairy buyers, feedlots, stockyards, and grain mills, to name a few. These entities all own a physical commodity at one time or another, be it grain, milk, livestock, etc.

Their goal is to offset the financial loss (or gain) in value of that physical good during the time they own the good.

For example, an observant farmer might see that the price of corn at harvest is sinking lower and lower, as measured by the December corn futures price. Since the farmer will own the corn he grew this fall, he may decide to hedge his price risk by setting a “price floor” for his corn.

A price floor is a minimum price that one can receive that is at a level that is still profitable.

There are numerous ways for sellers to set these price floors and price ceilings for those purchasing physical goods. These can be futures transactions for sales and/or purchases of the physical goods. The alert farmer of old was able to call the local elevator in May and secure a contract to deliver corn at harvest. These bushels have a “price” and will not decrease in value, creating a floor.

A seller or buyer could also trade futures and options on the Chicago Mercantile Exchange to hedge their position. For example, the farmer who wants to set a minimum crop price for corn in May might sell a December corn futures contract. They plant, grow and harvest the crops. If the price has fallen, they can buy back the December corn futures contract at the lower price, giving them a profit on the futures contract. This profit will offset the decrease in the cash price they receive for their corn, creating a price floor.

You may have heard the term “paper farming” in connection with trading “paper” or securities in the futures market. This term refers to hedging by creating offsetting positions in the futures market relative to the physical cash market – your local elevator, sales barn, etc.

We will discuss futures and cash market hedging strategies in more detail in future articles.

Fundamentally, our goal is to achieve a profitable price for the goods we market by managing price risk.

Success! An email has been sent to with a link to confirm registration to the list.

Mistake! An error occurred while processing your request.